No 2004/12: Jump Dynamics: The Equity Premium and the Risk-Free Rate Puzzles

Abstract: The paper develops a consumption based equilibrium model,
focusing on the risk premium and the risk-free interest rate. We derive
testable expressions for these quantities, and confront these with sample
estimates for the 20. century. Our framework is a dynamic model in
continuous time, allowing for random jumps at random time points, in
addition to diffusion uncertainty. Preferences are time separable and
additive.

The classical equity premium puzzle and the risk-free rate
puzzle are re-examined. We present values for the parameters of the
representative agent's utility function for different values of risk premia
and interest rates, calibrated to two first moments of the US-data of the
last century. Relatively low values for agents' risk aversion are
consistent with the model, but positive values of the subjective interest
rate seem harder to fit.

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